5 Things to Consider About Taxable Municipal Bonds

There's a small portion of the bond market that investors may have overlooked but now may want to consider—the taxable municipal bond market.

Most municipal bonds pay interest that is exempt from federal and potentially state income taxes. However, interest on some municipal bonds is subject to both federal and state income taxes depending on the taxpayer's location and applicable tax law. These bonds, known as taxable municipal bonds, generally pay higher interest rates than tax-exempt municipal bonds to make up for the lack of tax benefits.

We'll address the primary reasons investors may want to consider taxable municipal bonds, but first let's review the difference between taxable and tax-exempt municipal bonds.

Taxable municipal bonds pay interest income that's subject to federal and potentially state income taxes, whereas tax-exempt municipal bonds pay interest income that's generally exempt from federal and state income taxes.

Both taxable and tax-exempt municipal bonds are often issued by the same issuer and don't differ in credit quality. An issuer may choose to issue a bond as either a taxable or tax-exempt issue for a variety of reasons, such as the yield environment or to attract a different investor base to increase demand for their bonds.

Due to the different tax treatments between taxable and tax-exempt municipal bonds, taxable municipal bonds may be an attractive option for investors in lower tax brackets or for tax-advantaged accounts like an individual retirement account (IRA). Investors in higher tax brackets may still want to consider tax-exempt municipal bonds for taxable accounts, like a brokerage account, as they may yield more than taxable municipal bonds after considering the effects of taxes.

Yields for taxable municipal bonds are attractive, in our view, compared to tax-exempt municipal bonds of similar maturities. For example, since January 2010, on average, an index of taxable municipal bonds has yielded 1.0% more than an index of tax-exempt municipal bonds. Only during a brief period in March 2020 when the market was very volatile due to the onset of the COVID-19 pandemic crisis did taxable municipal bonds yield less than tax-exempt municipal bonds. Although that difference has come down recently, today, it is about 1.2% which is above the longer-term average.

Another potential benefit of taxable municipal bonds is that they're generally higher in credit quality than other alternatives. For example, 79% of the taxable municipal market is rated in the top four rungs of credit quality–AA minus or above.¹ This compares to 82% for the tax-exempt municipal market and only 8% of the corporate market, as illustrated in the chart below.

Since the start of 2010, an index of taxable municipal bonds had returned an average annual total return of 4.9% outpacing corporates, Treasuries, and tax-exempt municipal bonds. However, this is an average and can substantially vary by year. For example, as shown in the chart below, the best 52-week total return for taxable municipal bonds was just shy of 25% while the worst 52-week total return was just over -22%. In other words, on average, total returns for taxable municipal bonds are better than corporate tax-exempt municipal bonds and Treasuries, but the volatility is greater too. Total return is composed of the yield that an investor receives as well as any price fluctuations. The yield component has generally been the largest driver of total returns over time. This bodes well for future total returns because yields today are elevated and can help buffer any negative price changes.

The amount of newly issued taxable municipal bonds has been declining recently. Couple this with the fact that the taxable municipal market is much smaller than many other fixed income markets, as illustrated in the chart below, and investors may have a hard time finding enough taxable municipal bonds to achieve adequate diversification. Additionally, smaller markets are generally less liquid than larger ones, like the Treasury market, which means that it can be more difficult to sell your bond if you need to. Therefore, we suggest that if you're considering taxable municipal bonds, plan on holding them until maturity. The smaller market and lower liquidity of taxable municipal bonds is also an issue for investors in funds like exchange-traded funds (ETFs) or mutual funds.

Due partly to the size of the market, there aren't many mutual funds or ETFs that invest solely in taxable municipal bonds. In fact, there is only one open-ended ETF that we know of that invests in taxable municipal bonds and doesn't use leverage. Leverage generally means using borrowed funds to try to amplify returns. However, leverage can also amplify negative returns. Bonds that are less liquid are generally more volatile in times of market stress.

First, the taxable municipal index has a longer average duration—which makes it more sensitive to changes in interest rates—than the tax-exempt index. For investments such as ETFs or passively managed mutual funds that simply track the index, investors are taking on greater interest rate risk with taxable municipal bonds compared to tax-exempt municipal bonds. This is important because if rates rise , total returns for taxable municipal bonds may underperform their tax-exempt counterparts even more.

For investors in high tax brackets, we generally don't see value in taxable municipal bonds. However, investors in lower tax brackets or those investing a tax-sheltered account like an IRA may want to consider a small allocation to taxable municipal bonds to complement their other fixed income holdings. However, be aware that the size of the market can make it difficult to invest in.

Schwab clients can log in to their accounts and search for individual taxable municipal bonds.  If you need additional help, reach out to a Schwab Fixed Income Specialist.